How Fed Could Increase QE, Not Taper It

Worried investors are contemplating an end of the Fed's super-easy monetary policy after an article in the Wall Street Journal on Monday, but one analyst has detailed how the Fed may actually be set to increase the pace of quantitative easing (QE), not reduce it.

"Developments in the inflation data make it worth considering, at least, the idea that the Fed could conceivably find itself pushed into increasing the pace of QE," Ian Shepherdson, chief economist at Pantheon Macroeconomic Advisors said in research note.

Core inflation data for the U.S. has shown little movement in the last few months, with March's reading coming in at 1.9 percent -year-on-year, compared with September's figure of 2.0 percent. However, the PCE (personal consumption expenditure) deflator rate gives a different picture, Shepherdson said. March's reading showed a 1.1 percent increase year-on-year while September's number showed a 1.5 percent year-on-year increase.

"It puts the core PCE rate at its lowest rate since March 2011, at the end of the intense burst of disinflation pressure following the crash," he said.

"The core PCE deflator is the Fed's preferred measure of inflation. A downshift of the pace recorded over the past six months is certain to have set at least some bells ringing in the bowels of 20th Street and Constitution Avenue N.W."

We can't be certain core PCE inflation will continue to slow, Shepherdson added, but neither can we be certain the downshift is over.

"We can be pretty sure that if core PCE inflation were to fall to zero, the FOMC (Federal Open Market Committee) would be forced to act aggressively to prevent the disaster of deflation, almost regardless of labor market developments, and that would likely mean a substantial increase in the pace of QE," he said.

The next release for personal income and outlays data for April is due May 31.

Last week, the Federal Reserve reiterated its plans to continue buying bonds at the aggressive pace of $85 billion per month. This was widely expected, but the Fed also hinted that it could decide to do even more if employment growth and inflation do not meet its targets.

But according to the WSJ, Fed officials have mapped out a strategy to wind down this program in careful steps. Such a move could dampen investors' confidence; global equities and bonds rallied on the back of extra liquidity by central banks. Bond prices for Treasurys have pushed lower since the news.

"Reactive nonsense," Bill Blain, a senior fixed income broker at Mint Partners said in a morning note. "The Fed has made clear we need to see clear evidence of growth, not just hints, before they change course."

Kit Juckes, global head of FX strategy at Societe Generale said is it looking more and more likely that the Fed's exit strategy will be anything but transparent.

"Where Mr Bernanke charges in to easing, he tip-toes out. That's why risk assets like the man so much! The market interpretation is that this remains a green light for Treasury sellers and that in turn prompts the question of how far the S&P can rally in the face of rising yields," he said.